9 investor considerations about unicorns (1/2)

‘Unicorn’. No longer than 18 months ago, this word represented a sign of recognition for any start-up founder and a hardly coveted target for venture capitalists, who needed to have at least one specimen of this new species to appear as credible investors. Times have changed and the current environment has triggered 9 remarks I thought worth sharing in this post. As usual, the article ended up being longer than expected, so I will post the first 5 remarks today and the last 4 later this week.

Credits: www.p101.it
Credits: www.p101.it
  1. Signs of an overheating market are apparent in the US but more debatable in Europe: In the US the National Venture Capital Association noted that the VC industry deployed more capital in 2015 than any year since 1995. As a result, the US have become the most favourable breeding-ground for unicorns in the making: in 2015 the US gave birth to 30 of these ‘animals’ compared with 10 in Europe and 19 in Asia.
This used to be considered the next Facebook...
This used to be considered the next Facebook…

2. Painful write-downs have already started to take place: Beyond the Rocket Internet case, which results from more than a pure shift in market sentiment (see point 6), established brands, such as Dropbox, have not proven immune to write-downs. More generally tech values are relatively prone to valuation fluctuations, Zynga being a good historical example. In the same vein, Supercell could be the next one? Before the summer Tencent purchased 73% of the maker of Clash of Clans on the basis of a $9bn valuation, equivalent to 10 times trailing EBITDA – reasonable for an asset-light, well established company but more debatable for a company operating in the ‘boom-and-bust’ video game industry. Defunct unicorns have even been given the name of ‘unicorpses’ – Powa and Mode Media are part of the list.

Share price evolution of Zynga since IPO. source: Yahoo Finance.
Share price evolution of Zynga since IPO (in USD). source: Yahoo Finance.

3. The IPO window has become more selective and has left companies stranded: Nothing comparable with the dot-com bubble. The IPO path has consistently represented only c.15% of exit value over the last few years. The average time between first funding and IPO – when it happens – is now 8 years. Even well-established names can struggle to generate enough investor interest to justify an IPO. Deezer was one of the most recent victims, having had to cancel a $300m IPO in October 2015 (based on a c.$1bn valuation), officially because of ‘tough public market conditions’. The fact that the firm was still €27m in the red in 2014 could have contributed to the unease of public markets but did not deter private investors, who injected an additional $109m into the company a quarter later. Today companies IPO to raise relatively low amounts – despite being branded a unicorn Coupa plans to raise only $75m from public markets.

4. Unprofitable strategic decisions have been driven by a shift in key valuation metrics: The days of the ‘EV/eyeballs’ metric used during the 1990s ‘dot-com’ era are hopefully long gone. This does not mean that valuation excesses have disappeared altogether though. For loss-making ventures, using EV/revenues has appeared as the norm despite obvious biases. In that respect, a new unicorn is on average valued at 3x revenues in Europe and 8x revenues in the US – far greater than other more mature companies in the tech sector.

sans-titre
EV/revenues ratios for selected companies. Sources: CapIQ, author research.

Profitability concerns are not (yet) addressed, which explain why so many venture capitalists are funding growth at all costs, even if it means subsidising the sale of products – and therefore fuelling deflation, as explained in one of my earlier posts. The traditional EV/EBITDA ratio is making a powerful comeback this year, in particular when investors are dealing with late-stage ventures – a reason why Uber used ‘accounting magic’ to move the figure into positive territory, see the next point.

“The tech IPO is dead. But great tech companies can – and will – still go public.”

(Ravi Mhatre in TechCrunch)

5. ‘Adjustments’ are plasters on a broken knee: Reaching the break-even point is a big deal for a start-up. Often CFOs will stretch their financials a bit to reach this milestone. Uber announced a positive ‘adjusted net income’ in June this year – although adjustments take out significant cost items such as interest, taxes, employee stock benefits and losses in developing economies such as China.

[to be continued…]